Stress testing is the best preparation for extreme scenarios

In 2015 we saw a Greek drama play out in the form of ‘Grexit’ while unrest in the Chinese markets caused minor panic around the world. This year we may well encounter more of these extreme scenarios (such as Brexit for example).

In extreme scenarios, investment and risk managers are not helped with standard key ratios such as Duration, Greeks, etc. as these are too simple. Meanwhile complex risk measures such as ex-ante volatility and Value at Risk are only useful as trend measures. The only measure that is really helpful in extreme scenarios are stress tests combined with a good deal of ‘worst case scenario’ and out-of-the-box thinking.

Stress testing is intuitive and something everyone tends to do in their head when we worry about something in our lives. It is therefore a measure we can relate to as it basically translates to: ‘what impact would it have on me if X, Y or Z were to happen’. For many of the extreme events we have seen historically it would have been difficult to predict when and how they were to happen. Terror attacks and political events can happen out of the blue sometimes, and have negative and lasting consequences that are hard to predict.

However, other events are easier to prepare for.

It is, for example highly recommended to estimate daily how much you would lose in case any one of the companies you are exposed to went bankrupt from one day to another. After the financial crisis, this is something everyone recognized as possible – even to well-known and highly rated companies.

Then there are events that are scheduled and you can prepare by estimating the impact the events will have on your firm whatever the outcome. Typical examples of such events are political elections. They are usually scheduled well in advance and you know when the ‘extreme scenario’ could potentially occur. The US Presidential election this year for example has lined up some candidates that could impact the markets if they were elected. Even if it looks like the outcome of such an election is known well in advance, it is still worth lining up what could happen and see how it might impact the value of your positions.

An upcoming scheduled event that could have a significant impact on market values is the upcoming British referendum regarding the EU later this month. A lot has already been written and estimated relating to the possibility of ‘Brexit’. In particular for our industry, there are many guesses/estimates on how it would impact the British Pound FX rates, how British equity prices will react, yield curves, etc. It is also predicted that Brexit won’t just impact the British markets, but also many of their key trading partners.

Should the UK decide to remain within the EU then it will likely have a significant ‘relieving’ effect on the markets. Either way, extreme scenarios ought to be tried out so that you are prepared and can potentially decrease some of the exposures if the risk appetite is exceeded.

In the latest release of SimCorp Dimension it is possible to calculate a long list of sensitivity analytics in the stressed scenarios in the front office. It is not only possible to create extreme scenarios and calculate an accurate profit and loss scenario, it is also possible to see how that extreme scenario would change the exposures, expressed via Duration, Greeks, etc. This enables users to apply an extreme scenario, reflect on the P/L in case it happens and whether you should re-hedge your positions.

This is particularly important for portfolios where non-linearity could imply that you end up with significantly higher exposure and this being an extreme scenario where you have to react quickly as the market liquidity has decreased. Financial institutions who are prepared for these re-hedges can obviously react quicker and thereby most likely come out stronger than their peers from an extreme event.